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Just Waiting for the Shaking to Stop

Obama started backing off the “absolute default” tactic by today saying “This week, if we don’t start making some real progress both in the House and the Senate, and if Republicans aren’t willing to set aside some of their partisan concerns in order to do what is right for the country [ed. note: our guys are always the patriots and the other guys are always the partisans, right?], then we stand a good chance of defaulting.” So, it’s no longer a sure thing, and the hurdle he has laid out is “good progress” rather than a hard stop.

As I have said before, there should be no default even if there is no agreement reached in our day. There simply is no reason to default unless the Administration decides it is politically opportune to do so. Last week, White House spokesman Jay Carney said “prioritization is default,” meaning that the government would somehow be defaulting by choosing to pay debtholders before others, but that’s simply wrong. Servicing the bonds is most assuredly not a default no matter what else you do. Carney might mean “prioritization is a bad political situation for us,” and he might mean “not paying some vendors would be, if we were a private company, grounds for being forced into bankruptcy,” but the US Govt isn’t a private company and there is no way to force it into default if it services its debt. And it is interesting that the President is now walking back his threats that a default was inevitable if no agreement is in place by the time the debt ceiling is reached.

I am not so sanguine that the current developing deal in the Senate is going to end the impasse. Although Senate Republicans seem willing to give the Administration all that it wants, and probably to apologize as well, the House Republicans already tried their version of a complete surrender and it was roundly rejected by the Administration (and why shouldn’t it be rejected? With the government shut down and the constant threat of default in the air, stocks are +1.7% this month. Toy with us some more, please!). By the time this crisis is over, the Republicans will probably be offering to repeal the 22nd Amendment and let Obama serve another term!

If, in fact, the standoff is resolved, it remains to be seen how quickly all of the economic data releases get back on line once the government is back at work. In any case, some of the data from this month will be suspect because the regular collection procedures will not be followed. For example, even if CPI is released on Thursday (or delayed and released before the end of the month), it will not be based on a full month’s regular survey of prices since for the last week or two no one has been collecting prices. This will be corrected in the next release (since what the price collectors are surveying is the level of prices, not the change in prices), but it may lead to near-term confusion due to the indeterminate effects. Other releases suffer from similar problems of greater or lesser order, but considering how important CPI is right now this is a prime concern.

It is a prime concern right now firstly because the artificial inflation trough induced by the original sequester has passed and inflation will be rising going forward, and secondly (and more importantly) because we will soon have a new Federal Reserve Chairman in Janet Yellen who will have to confront the issue very quickly and either burnish or reject her dovish credentials. So far, it seems clear to most of us that Yellen is a committed dove although a story that circulated in late September tried to argue that since she had been an advocate of a formal inflation target it means she is actually a hawk.

Favoring an annual inflation target has almost no implications for interpreting whether a monetary policy maker is a hawk or a dove. In fact, of the various targeting regimes proposed the non-correcting annual target is the most dovish proposal. That’s because there is no penalty for missing the target. With this sort of target, if you have 2% inflation followed by 20% inflation followed by 2% inflation, you’re back on target and the central bank need do nothing further. But, of course, prices are much higher than if you’d experienced 2%, 2%, and 2%. Other proposals, such as the long-term price-level proposal, force the central bank to steer to a particular compounded inflation level, which means that a big miss to the upside must be “paid back” by a subsequent miss to the downside. Now that is a much more hawkish proposal, because it defends long-term inflation levels rather than declaring a toothless goal. (You can read more about inflation targeting in my article here from 2010). Yellen is among those who thinks it’s important to convince everyone there is a goal, because “grounded inflation expectations” (even if they’re not rationally grounded but rather grounded because you tricked consumers into thinking you really have a target) help to restrain inflation. And on this point there is really not much evidence.

But it also misses the point in the extant environment. If Yellen desires to limit inflation, merely stating that she wants inflation to stay around 2% isn’t a policy action, or even a policy preference. It’s merely an expression of her preference for possible states of the universe. My children do approximately the same thing, with the same effect, when they say “I wish we could have a horse/travel to the Caribbean/build an indoor pool.” Yeah, and I wish I had a Jaguar, too.

Wishing doesn’t make it so. If Bernanke/Yellen want to limit inflation to 2%, merely talking about it is insufficient. What Yellen needs to do is to take action now. (Actually, they needed to take action two years ago, but it’s like James Carville famously said: “the best time to plant a tree was twenty years ago. The second-best time is right now.”) To the extent that Yellen is not urging action to reduce the Fed’s balance sheet and restrain future money growth it means that either she doesn’t really care about 2% inflation, at least in the near-term, or she doesn’t understand what causes inflation. I suppose I hope it is the latter cause, since that would be consistent with Bernanke’s position: he probably cares about limiting inflation but doesn’t understand that letting the balance sheet grow without bound is among the worst things he can do to limit inflation in the medium-term.

  1. eric
    October 16, 2013 at 2:32 pm

    now im hearing “no taper until June.” The fed clearly (correctly) views fiscal policy as broken and (incorrectly and/or desperately) believes it can make up for it with monetary policy.

    • October 16, 2013 at 2:38 pm

      Yeah, hard to imagine a scarier setup. With Yellen in charge and 2014 likely to see more fiscal shenanigans and probably slowing growth, I think the only reason we might get tapering is that core inflation is going to be going up above 2% pretty soon. They won’t care until 2.5%, and even then they’ll probably only begin a taper rather than actually removeliquidity. Scary setup.


  2. eric
    October 16, 2013 at 2:57 pm

    I guess if I had to pick, I would go with “desperately” rather than “incorrectly” (by which I mean, more precisely, “as a result of a poor understanding.”) And the desperation is also fueled by their belief (also perhaps born out of desperation) that “inflation is contained.” So, yes, taper will begin only when they can see the whites of inflation’s eyes–however they understand that. Then they are going to need some very big sponges to sop up all those reserves.

    What’s your current opinion about the best (retail) way to trade breakevens. I’m finding the ETN, especially INFL, difficult to deal with.

    • October 16, 2013 at 7:22 pm

      Unfortunately, UINF and INFL have both been plagued by fairly bad liquidity. I prefer UINF theoretically as it is a more-pure instrument, but INFL seems to have better liquidity all else equal. Unfortunately, that’s about the only way for retail to trade breakevens other than buying a TIPS fund and shorting a bond ETF, and that’s hard to weight correctly. I spent a lot of time working with the CME to get CPI futures re-listed, but they ended up deciding against doing it because no one on the buy side would promise to trade thousand-lots on the first day. I am exaggerating very slightly; the main point though was that they had ridiculously high requirements for initial liquidity and the futures contract (and a TIPS contract) have both died on the vine despite the fact that there were several firms willing to be market-makers (including ours).

      So, unfortunately, there remain no clean ways to get long breakevens…for now, anyway.

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